Many businesses take out loans in the early days to fund big purchases or investments. But what happens when you find yourself strapped for cash a few months or years in? That’s when working capital financing comes in handy.
There are several reasons why a business may pursue working capital financing (also called working capital loans). One of the most common reasons is a seasonal operating schedule.
Seasonal businesses like summer camps, holiday shops, and some e-commerce businesses often experience a high sales volume for part of the year, followed by long periods of low volume. These businesses play an important role in meeting consumer demands but may need working capital financing to get them through the rest of the year.
Let’s take a look at how working capital financing works and when it might be worth considering.
What is working capital financing?
Working capital financing is a short-term loan that’s meant to cover day-to-day operations such as payroll, rent, and inventory purchases. Unlike long-term loans, which generally cover overhead costs, working capital loans are intended to cover immediate and ongoing needs.
Obtaining working capital financing can make the difference between a sustainable business model and falling prey to the statistic that half of small businesses fail within the first five years.
Pros and cons of working capital financing
Like any loan, working capital loans come with pros and cons. Pursuing this type of funding takes careful consideration. Oftentimes, the pros outweigh the cons—but not always.
Pro: The amount you can borrow grows as your business does
Contrary to popular belief, working capital loans aren’t meant for businesses that are “failing.” In fact, many lenders require a minimum revenue to qualify for this type of loan.
Successful businesses take advantage of these loans to keep operations steady and to keep cash on hand. As your business grows—and your business expenses grow with it—the amount that you can borrow increases.
Pro: An easy way to get financing
Long-term loans are notorious for requiring a lot of paperwork and having a lengthy application process. On the other hand, working capital financing typically gets approved more quickly, as long as you qualify for it. The barriers to qualification are also not as high as other types of loans. The result is quick access to relatively inexpensive loans.
Pro: More cash on hand
If your burn rate is high, you might be tempted to downsize your operations to cut costs. Working capital financing gives you another option. It takes care of your day-to-day expenses and leaves room for you to use any cash you have on hand to explore expansion opportunities or make other investments.
Pro: Your business stays yours
There are several forms of financing that require a trade. This often means exchanging equity for funding. For business owners who prioritize keeping a full stake in their business, short-term loans offer an opportunity to patch financial complications while maintaining full control over their business.
Con: Not ideal for companies without revenue
Working capital loans are meant for businesses that are already in operation and can predict when they will make revenue. Because of the short-term nature of the loan, it is not ideal for ventures that are still unproven.
The first reason and most obvious reason is that many institutions require a minimum amount of revenue to consider you for the loan. But even if the loan is offered, you have to be confident that your business will make enough in the short term to cover the amount borrowed. If you’ve never made money with your venture, then it’s difficult to calculate when you’ll be able to pay the loan back.
Con: You may need to adjust credit, billing, and other practices
While a working capital loan is easier to access than other loans, it still requires monitoring financial metrics such as your credit and cash flow. Be sure to understand how the loan will impact your credit score and double-check whether the lending institution is using your business credit or personal credit.
Also understand how your billing practices affect your ability to qualify or pay back a loan. Before taking on a loan, consider making your business leaner by reducing costs or selling unneeded assets. This way, if you decide to take on a loan, you know the borrowed amount will go towards necessary costs.
Con: Limited time to pay back
Working capital loans usually involve short repayment periods, often measured in months instead of years. If you aren’t confident that your business will make enough to repay the amount you’re borrowing in the time period set, then this may not be a good fit. Not being able to pay back your loans can have a negative impact on your standing with financial institutions (i.e. your business credit score).
Different types of working capital financing
There’s more than one way to tap into working capital. To make the best choice for your business, take a look at your current revenue, verified purchases, and where you plan to spend the money you borrow.
Working capital revolvers
Working capital revolvers are named this way because the loans are “revolving.” This means that once you pay off the amount you borrowed, it’s credited to your account and you can borrow it again. It works similarly to a credit card, where a maximum limit is set and you can borrow from it over and over again.
Let’s say your lending institution sets the limit at $10,000 and you borrow $3,000. You have $7,000 available to borrow. If you pay off $2,000 of the borrowed amount, it will go back to your credit line and you will be able to borrow up to $9,000.
The limit can be adjusted as your business grows. As you prove that you are able to reach higher revenue goals, your limit may increase.
Purchase order financing
Purchase order financing is for businesses that need capital to deliver on customer purchases. Let’s say you’re getting off the ground as a bakery and secure a customer that orders 10x the amount of baked goods you usually deliver. You may not have enough cash on hand to buy all the ingredients necessary to complete the order.
Purchase order financing gives you a way to buy the ingredients, complete the order, and get paid. Then, you pay back the loan plus interest when your customer pays you. This allows you to grow your business by completing orders that would otherwise be too expensive to pursue.
While most types of working capital financing come from banks or other financial institutions, vendors can also extend a “loan” to clients. This is not necessarily a formal process, but rather an agreement you make with your vendor. They may offer deferred payment with interest or another form of a loan. Keeping strong relationships with vendors is valuable and good vendor management increases your chances for this type of loan.
How to apply for working capital financing
As explained above, not every loan will come from an official lender. If you’re aiming for vendor credit, you will have to approach your vendors on a case-by-case basis. If you’re looking to take a more standard approach, here are the steps for securing a working capital loan.
Banks and credit unions
Because they are traditional institutions, banks and credit unions require more paperwork and longer wait periods than online lender platforms. The trade-off is that they are often able to offer greater borrowing amounts at lower rates.
Step one is to understand what information you need to submit. This often involves tax forms, a business credit score, a business plan, and other documents that prove the longevity and stability of your company.
After submitting these documents, expect to hear back in a few weeks or months as the institution conducts its underwriting process. They may follow up for more information or require collateral to reach a final decision.
Online lender platforms
Online platforms are ideal for businesses that have been operating for less than two years, haven’t built up their credit score, or need a quick response. The application process is typically less document-heavy and may be based on revenue or a personal credit score.
How Ramp can help you increase your working capital through commerce sales-based underwriting
Not all lenders keep up with the reality of modern businesses. Ramp offers commerce sales-based underwriting to serve as working capital for businesses that may struggle with traditional lending processes.
Let your revenue speak for you
Traditional underwriting looks at cash on hand as a signal for business health. But this doesn’t line up with how many businesses work, especially if your business is inventory-based. Ramp uses a commerce sales-based underwriting method that allows your access working capital to increase as your sales volume grows.
Control your capital with automated expense management
Ramp goes beyond loans by giving you spend management tools to help you see where your borrowed money is going. By keeping your spending in a centralized platform, you can make data-driven decisions on where to spend and where to cut costs.
Build your business credit for the future
If your long-term plans involve taking out loans or lines of credit with traditional institutions, Ramp can be your first step in building business credit. Your business credit becomes increasingly important as your business grows, so building your credit early will give you a head start.